The New Rule of 40: Why Median SaaS Firms Are Trading at a Discount

The 12% Reality Check: Why Your Portfolio is Leaking Value

For the better part of a decade, the "Rule of 40" was a polite suggestion—a slide in a board deck that everyone nodded at before approving a plan that burned cash to fuel 60% growth. As long as topline revenue was climbing, the multiple would take care of itself. That era is dead.

Today, the median private SaaS company isn't hitting 40%. It isn't even hitting 20%. According to Q1 2025 data from CloudZero and KeyBanc, the median Rule of 40 score for private B2B SaaS companies sits at a meager 12%. This creates a massive bifurcation in the market:

• The Elite (Top Quartile): Firms scoring 40%+ are commanding premium multiples (7x-10x ARR), driven by durable, efficient growth.
• The Median (The Trap): Firms stuck in the 10%-20% range are seeing valuation compression, trading at 3x-5x ARR, often forcing down-rounds or structured exits.

For Private Equity Operating Partners, this 12% benchmark represents a crisis of operational discipline. You likely have portfolio companies that are growing at 15% but running at breakeven (Rule of 15), or growing at 30% while burning 20% (Rule of 10). In the current exit environment, these assets are illiquid. Strategic acquirers and secondary markets are no longer paying for "growth at any cost." They are paying for Efficient Growth.

Defining the Calculation for PE Sponsors

While venture capitalists might accept Free Cash Flow (FCF) in the calculation, the Private Equity standard is stricter. We measure Rule of 40 as:

Rule of 40 = ARR Growth % + EBITDA Margin %

We use EBITDA because it is the proxy for the debt serviceability and operational leverage you need for a recapitalization or exit. If your portfolio company is relying on adjusted FCF to hit the number (by delaying payables or capitalizing software aggressively), you are masking the underlying operational inefficiency.

2025-2026 Benchmarks: The Valuation Cliff

The gap between "good" and "great" has widened. Data from ICONIQ Growth's 2025 State of Software and KeyBanc's market surveys illustrates a stark valuation cliff based on efficiency scores.

The Benchmark Tiers

• Failing (<20%): The danger zone. These companies are burning cash without sufficient growth to justify it. They are candidates for aggressive restructuring or distressed M&A.
• Median (20% - 35%): The "No Man's Land." This is where most decent companies stall. They are investable but will not drive multiple expansion.
• Healthy (40% - 50%): The target. This balance signals a firm that can self-fund growth or throw off cash.
• Elite (>50%): The valuation premiums here are non-linear. These assets command the highest demand because they prove the business model has true operating leverage.

The "Weighted" Rule for Early Growth

If you are managing a Series B/C asset doing $10M-$20M ARR, a pure Rule of 40 might unfairly penalize high growth. Investors increasingly look at the Weighted Rule of 40 (sometimes called the Rule of X), calculated as:

(2 × Growth Rate %) + EBITDA Margin %

This weighting acknowledges that for companies under $50M ARR, growth is twice as valuable as profitability—provided the unit economics are sound. However, as the company crosses $50M ARR, the weighting shifts back to 1:1. You cannot outgrow bad margins forever.

See our deep dive on SaaS EBITDA Benchmarks by ARR Band to understand how your portfolio's margin profile should evolve as it scales from $10M to $50M.

The Turnaround Plan: Fixing a Broken Score

If your portfolio company is sitting at a Rule of 12, simply "cutting costs" is a blunt instrument that often kills growth. You need a surgical approach to Unit Economics. Here is the operator's playbook for correcting the ratio:

1. Pricing Power (The Purest EBITDA Lever)

Most founder-led firms haven't raised prices in 3 years. A 10% price increase drops directly to the bottom line, immediately improving your Rule of 40 score by increasing both the numerator (Growth) and the denominator (Margin). It is the single most efficient lever available.

2. Gross Margin Hygiene

Stop treating Implementation and Customer Success as "Marketing expenses." If your Gross Margins are below 75% for pure SaaS, you have a delivery problem. Move non-recurring engineering and low-margin professional services below the line or automate them. High COGS are the silent killer of the Rule of 40.

3. GTM Efficiency (CAC Payback)

You cannot cut your way to growth, but you can stop buying bad revenue. If your CAC Payback is over 18 months, your growth is toxic. It degrades your EBITDA faster than it adds ARR. Cut the bottom 20% of performing reps and redirect that spend toward channels with proven LTV/CAC ratios.

4. Founder Extraction & OpEx

Finally, look at General & Administrative (G&A) bloat. Is the founder still playing "Chief Everything Officer"? This often leads to redundant hires to support the founder's lack of process. Documenting systems and removing key-person dependency often allows you to reduce headcount while improving velocity.

Conclusion

The market has spoken: Growth at all costs is over. The Rule of 40 is no longer an aspiration; it is the gatekeeper to liquidity. Whether you are prepping for a 2026 exit or stabilizing a wobble, the math is unforgiving. You are either an efficient compounder or a distressed asset. Choose accordingly.